Lease financing is an age old financing agreement type where a lessee buys or rents capital equipment from lessor for an agreed period of time. The accounting of these transactions, w.e.f. April 1, 2019, is governed by Ind AS 116 “Leases”, issued by Ministry of Corporate Affairs. This article summarizes the provisions of newly introduced accounting principles and discusses the major changes that will affect the books of accounts.
Meaning of Lease
“Lease” is a contract or part of contract that allows a party known as lessee to control the right to use an identifiable asset for consideration to a second party known as lessor over a period of time”.
Key Points of Ind AS 116
- Whether a contract contains a lease or not is determined at the inception of the contract. The inception date is earlier of date of contract or when the parties agree to terms and conditions of the contract.
- The asset may be explicitly stated or implicitly covered in the contract. For instance, ABC ltd. enters into a contract with XYZ ltd, for the use of a car specifying its features. However, the car is not yet built. The car is the said implied asset in the lease.
- The right to control the use of the asset is determined by assessing the contract on two points: whether the customer has the right to obtain substantially all the economic benefits from asset and he has the right to direct the use of the asset.
- A lease term starts when the lessor gives lessee the underlying asset for use. It shall include
Accounting from Lessee’s point of view
Ind AS 116 introduces a single lessee accounting system where all the leases have to be accounted for in the books of accounts. Lessee needs to recognize right to use the asset at cost and a subsequent lease liability at present value of the lease payments. The present value is calculated using the interest rate implicit in the lease. Ind AS removes the distinction between operating lease and finance lease for lessee. However, the following two transactions are exempted from the Ind AS accounting:
- Leases with term less than 12 months
- Low Value leases i.e. underlying asset is not highly dependent on other assets.
Subsequently, depreciation is charged on “Right to use” the asset and interest is calculated on the lease liability. Any impairment on “Right to use” is also calculated.
Example of accounting entries in the books of lessee:
|
Initial Measurement |
|
|
Right to use the Asset |
xxx |
|
To Lease Liability |
xxx |
|
Subsequent Measurement |
|
|
|
|
|
Depreciation |
xxx |
|
To Right to use the Asset |
xxx |
|
` |
|
|
Lease Liability |
xxx |
|
Interest on Lease Payments |
xxx |
|
To Vendor |
xxx |
Accounting from Lessor’s point of view
Lessor has to account for incoming stream of rent from operating lease or finance income from finance lease in his books. A lessor has to classify between an operating lease and finance lease. A lease is an operating lease where all the risk and rewards implicit in the contract are not transferred to the lessee. Few points to be noted here are:
- Under finance lease, lessor derecognizes the underlying asset and has to present lease receivables at the investment amount. Finance income has to be recognized over the lease term
- Under operating lease, any initial costs incurred shall be added to the asset recognized in the balance sheet.
Difference between Ind AS 116 and Ind AS 17
|
Nature of Difference |
Ind AS 116 |
Ind AS 17 (Existing) |
|
Accounting Model |
Single accounting model for all the lessee i.e. all leases to be accounted as finance lease |
Classification of leases into operating leases and finance lease in the books of accounts of lessee. |
|
Lease Definition |
Under this, the lessor gives the right to control the use of an asset to the lessee. |
Under this, the lessee gives the right to use the asset to the lessee. |
|
Short term lease exemption |
Assets with lease period less than 12 months and are low value can, optionally, be treated as per Ind AS 17. |
No such provision was required or existed. |
|
Effect on the Balance Sheet of lessee |
The balance sheet will reflect the right to use contained in all the leases on the asset side and due Minimum lease payments on the liabilities side. |
Only the lease recognized as finance leases were to be reflected in the Balance Sheet |
|
Effect on Profit & Loss Statement of the lessee |
The profit & Loss statement will reflect depreciation on the right to use the asset and interest payments due on lease liabilities. This may cause higher expenses in the initial years of the lease |
Lease payments were recognized as an expense on straight line basis or other systematic pattern. |
|
Effect on Cash Flow Statement |
Lease repayments and interest thereon will be classified under cash outflow from financing activities |
No such effect for operating leases |
|
Lease modifications to an operating lease |
Lessors have to account the modified operating lease as a new one from the date of modification. |
No mention in Ind AS 17 about this |
|
Disclosure in the financial statement |
Detailed Disclosure (including the format of disclosure and qualitative and quantitative information about leasing activities) is required |
Fewer disclosures as compared to Ind AS 116. |
Transitional Provisions
A lessee has been given an option to retrospectively apply the accounting standard fully by reinstating the comparatives for preceding financial years. Or the lessee can pass a single adjustment entry at the end of the current year, conforming the books of accounts to current accounting standard. This is a simplified approach and allows relief from complicated calculations.
Conclusion
Lease Contracts are pivotal to the business. Introduction of single lessee accounting model has simplified provisions for lessee. It is bound to make accounting more transparent and accountable.
- Ind AS 115 Revenue from Contracts with Customers - March 20, 2020
- Ind AS 116 Leases - March 12, 2020
- How To Become A Chartered Accountant - March 9, 2020
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